What Is a Buy-Sell Agreement? Do You Need One?
What will happen to your company when you retire, move on to a new business, or cannot handle your business responsibilities due to disability or death? A buy-sell agreement answers those questions before it becomes necessary.
A buy-sell agreement sets a clear path to tackle unpredictable events. Also known as a buyout agreement or shareholder agreement, a buy-sell agreement is a legally binding contract between two business partners. It outlines how business interests will be treated if one partner suddenly leaves the business. It is the most practical approach to safeguard the business, its customers and clients, and its employees and other stakeholders.
The events that usually trigger a buy-sell agreement are:
- Termination of employment or resignation
- Permanent disability
Having a buy-sell settlement establishes a clear plan to deal with such situations. Without an agreement, the issues such as tax hassles and financial and legal problems may plague the company.
When you establish a commercial partnership, you don’t intend to dissolve. Unfortunately, new business possibilities, disputes, and death may sever the existing business collaboration. Such circumstances make creating and signing a buy-sell agreement essential for all business partners.
What is this contract, and what does it cover?
What Is a Buy-Sell Agreement?
A buy-sell agreement is a contract that determines how a partner’s shares in an organization will be reassigned if one of the business partners departs, dies, or otherwise ceases association with that company. In such cases, the buy-sell settlement orders that the partner’s stocks be sold to the business’ remaining partners.
Business owners must understand how the agreement works since buy-sell agreements are not limited to managing the business after a partner’s demise.
How a Buy-Sell Agreement Works
- Identifies and determines which particular event(s) will trigger a buyout.
- Determines who in the business has “rights and purchase” responsibility.
- Identifies the names and contact details of the purchaser(s).
- Sets a purchase price or conducts the valuation with all applicable discounts.
- Sets the terms for payments with specified intervals (monthly payment, quarterly, half-yearly, or annually)
- Details what happens if a partner(s) decide not to use their purchasing rights
- Selects the most appropriate valuation method
- Specifies how the shares will be assigned and distributed.
Buy-sell agreements clarify how certain situations should be handled. Business partners mostly use these agreements, but a sole proprietor or a limited liability company can also use this type of agreement. Business owners harboring concerns over a partner suddenly leaving the business should not delay developing a buy-sell agreement.
When a buy-sell agreement is executed correctly, it safeguards the rights and privileges of all concerned parties. Ideally, the partners engage a corporate lawyer to draft and negotiate the terms of a buy-sell agreement.
When Your Business Needs a Buy-Sell Agreement
- To maintain the business continuity
- To safeguard the company ownership rights
- Eliminate or manage the chances of a dispute
- To protect all business assets
- To protect the rights of the business owners and safeguard the business
- Remove a future cause of stress from business partnerships.
Types of Buy-Sell Agreements
Selling shares in a business due to a triggering event needs serious consideration, especially when you own the company and are not just a partner. Don’t hesitate to consider all your options when drafting a buy-sell agreement. We recommend engaging a corporate lawyer to learn more about your ownership and other legal rights.
There are two basic types of buy-sell agreements.
In a cross-purchase agreement, each of the company’s shareholders or business partners agrees to purchase the shares of the business partner who has left the business due to death, retirement, or incapacitation. Before the shareholder or business partner leaves the business enterprise, they might sell their stocks to different shareholders or business partners.
Usually, to fund such an agreement, each business partner buys a life insurance policy to ensure the life of all other partners. When all the policies are added up, its proceeds equate to the purchase price of the deceased owner’s shares in the business. So, each business partner is both owner and the beneficiary of other owners’ individual life insurance policies.
For example, a business is valued at $600,000 and has three partners owning equal shares. So, each partner’s share is $200,000. To fund a cross-purchase agreement, the first and second owners purchase an insurance policy of $100,000 for the third owner. Likewise, owners 2 and 3 buy $100,000 for the first owner, and owners 1 and 3 buy $100,000 for the second owner. Therefore, each owner is covered by two policies. If an owner dies unexpectedly, the surviving owners can use the insurance proceeds to buy the deceased owner’s shares.
If the owners pay the premiums, those premiums are tax-exempted. If the business pays the premiums, the IRS taxes them as shareholder income.
Cross-purchase agreements confer the following benefits:
- A cross-purchase agreement ensures that the deceased owner’s heirs receive immediate cash in place of their inheritance.
- Control of the business stays with the surviving owners.
- The surviving business partners/ owners are assured of having adequate funds to buy out the deceased partner’s shares.
- A cross-purchase agreement also sets the deceased partner’s share value for federal tax purposes.
A stock redemption agreement is an agreement between a corporation and the stockholder, wherein the company is primarily responsible for redeeming the shares of the disabled or deceased owner. The corporation also has the right to refuse to purchase the deceased owner’s shares if a third party offers to buy them.
Under this agreement, the shareholder’s stock is returned to the corporation. If the stocks are redeemed with the deceased owner’s insurance policy, the corporation pays the policy’s premium and is the owner and sole beneficiary of that policy.
The costs associated with the insurance premium are distributed proportionately among all the shareholders since the corporation pays all the insurance premiums. So, a young shareholder or a shareholder with only a few shares is not asked to pay a higher premium to cover another shareholder who owns more shares. Furthermore, since only one insurance policy for each shareholder, all parties’ rights can be drafted in a single document.
A stock redemption agreement offers the following benefits:
- The agreement is simpler compared to a cross-purchase agreement.
- The business entity buys the deceased owner’s shares, so other shareholders need not worry about sourcing adequate funds to buy the shares.
- It is fairly easier to administer the policy if an owner leaves the business. However, the other owners do not benefit from stepping in under a cross-purchase agreement.
- The deceased owner’s heirs can settle debts and taxes and manage other expenses.
Do You Need a Buy-Sell Agreement?
Yes, you do!
A buy-sell settlement shields a business from financial difficulties due to co-owner departure. Your business needs a buy-sell agreement for the following reasons:
- To facilitate the sale of your shares by providing a ready pool of buyers and a determined value of the shares.
- To safeguard the business by preventing unwanted, third-party ownership or placing restrictions on the transferability of shares to stop a particular shareholder from acquiring more shares.
- To create a stable funding and liquidity mechanism so the company is not forced to sell or liquidate its assets if a triggering event occurs.
Buy-sell agreements are designed to help company owners control potentially challenging situations with methods that protect the interests of all shareholders and safeguard the enterprise and their personal and family interests. Forming a buy-sell agreement affords all shareholders clarity as to their goals. They should also clearly understand the implication of entering such an agreement and carefully consider all the parties covered by the agreement’s rights, duties, tax considerations, and financial responsibilities.